3 Oligopoly Environment Relatively few firms, usually less than 10. Duopoly - two firms Triopoly - three firms The products firms offer can be either differentiated or homogeneous. Firms decisions impact one another. Many different strategic variables are modeled: No single oligopoly model. 9-3

8 Key Insight The effect of a price reduction on the quantity demanded of your product depends upon whether your rivals respond by cutting their prices too! The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too! Strategic interdependence: You aren t in complete control of your own destiny! 9-8

12 Sweezy Oligopoly Summary Firms believe rivals match price cuts, but not price increases. Firms operating in a Sweezy oligopoly maximize profit by producing where MR S = MC. The kinked-shaped marginal revenue curve implies that there exists a range over which changes in MC will not impact the profit-maximizing level of output. Therefore, the firm may have no incentive to change price provided that marginal cost remains in a given range. 9-12

13 Cournot Model Environment A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated). Firms control variable is output in contrast to price. Each firm believes their rivals will hold output constant if it changes its own output (The output of rivals is viewed as given or fixed ). Barriers to entry exist. 9-13

14 Inverse Demand in a Cournot Duopoly Market demand in a homogeneous-product Cournot duopoly is Thus, each firm s marginal revenue depends on the output produced by the other firm. More formally, MR MR ( ) P = a b + 1 = a bq2 2bQ1 2 = a bq1 2bQ2 9-14

15 Best-Response Function Since a firm s marginal revenue in a homogeneous Cournot oligopoly depends on both its output and its rivals, each firm needs a way to respond to rival s output decisions. Firm 1 s best-response (or reaction) function is a schedule summarizing the amount of firm 1 should produce in order to maximize its profits for each quantity of produced by firm 2. Since the products are substitutes, an increase in firm 2 s output leads to a decrease in the profit-maximizing amount of firm 1 s product. 9-15

18 Cournot Equilibrium Situation where each firm produces the output that maximizes its profits, given the the output of rival firms. No firm can gain by unilaterally changing its own output to improve its profit. A point where the two firm s best-response functions intersect. 9-18

20 Summary of Cournot Equilibrium The output * maximizes firm 1 s profits, given that firm 2 produces *. The output * maximizes firm 2 s profits, given that firm 1 produces *. Neither firm has an incentive to change its output, given the output of the rival. Beliefs are consistent: In equilibrium, each firm thinks rivals will stick to their current output and they do! 9-20

26 Stackelberg Model Environment Few firms serving many consumers. Firms produce differentiated or homogeneous products. Barriers to entry. Firm one is the leader. The leader commits to an output before all other firms. Remaining firms are followers. They choose their outputs so as to maximize profits, given the leader s output. 9-26

32 Contestable Markets Key Assumptions Producers have access to same technology. Consumers respond quickly to price changes. Existing firms cannot respond quickly to entry by lowering price. Absence of sunk costs. Key Implications Threat of entry disciplines firms already in the market. Incumbents have no market power, even if there is only a single incumbent (a monopolist). 9-32

33 Conclusion Different oligopoly scenarios give rise to different optimal strategies and different outcomes. Your optimal price and output depends on Beliefs about the reactions of rivals. Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products). Your ability to credibly commit prior to your rivals. 9-33

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